TY - JOUR
AU - Woxholth, Jannik
AB - Key points One centerpiece of the European Commission’s Digital Finance Strategy of 24 September 2020 is the draft regulation on a pilot regime for market infrastructures based on distributed ledger technology (known as PilotR). The PilotR Proposal foresees a regulatory sandbox approach for the European Single Market, offering firms a set of exemptions from EU financial law that allow them to test distributed ledger technologies (DLTs) for trading, clearing and settlement. Besides offering room for experiment, the PilotR Proposal supports the education of EU regulators about DLTs in this context, which may come to form the basis for foundational changes to EU law. The PilotR Proposal constitutes a significant step towards a future-proof EU fintech framework. We appreciate the European scale of PilotR, with an ‘EU Passport’ and ongoing cooperation across competent authorities and the ESMA. PilotR is characterized by an innovative ‘Business Plan Approach’ where the DLT operator defines governance functions and liabilities of entities operating, and connected to, DLT. Through this Business Plan Approach, PilotR promotes innovation while demanding business-specific risk mitigation, avoiding one-size-fits-all approaches. This bold regulatory move, however, prompts legal questions regarding the enforceability of business-induced rules vis-à-vis the nodes that do not qualify as operators as well as third parties. We find that the PilotR Proposal would benefit from three amendments: First, EU legislators should articulate a clear link between the priorities laid down in the DFS 2020 and PilotR, along with an explanation of how PilotR fits into a broader set of measures to support innovation. Secondly, PilotR is characterized by a narrow scope with a relatively long timeline for testing, thereby the degree of mutual learning will be reduced. Thirdly, being limited to authorized MiFID firms and central securities depositories only, regulatory leniency will be reserved for incumbents—despite PilotR’s expressed objective to benefit innovative start-ups. 1. Introduction Financial technology (Fintech) is disrupting finance at a rapid pace, forcing a rethink on legacy financial regulation. In particular, the question of the regulatory treatment of crypto-assets and blockchain and distributed ledger technologies (DLTs) has been a major focus of regulators and market participants since the launch of Bitcoin in 2009, and further still since the crypto bubble of 2018.1 Yet, a more general question is even more important: How should innovation and the use of only partially understood technology be regulated? In Europe, this was for a long time up in the air. Since the European Commission’s Fintech Action Plan of 2018 signalled a determination to make beneficial use of technical innovation,2 the Commission has taken a broad approach by adopting on 24 September 2020 a new Digital Finance Package.3 That package comprised the new Digital Finance Strategy (DFS 2020)4 combined with a renewed Retail Payments Strategy,5 in an effort to ‘boost Europe’s competitiveness and innovation in the financial sector, paving the way for Europe to become a global standard-setter’.6 The Commission ‘aims to boost responsible innovation in the EU’s financial sector, especially for highly innovative digital start-ups, while mitigating any potential risks related to investor protection, money laundering and cyber-crime’.7 At the core of the Digital Finance Package lie the legislative proposals for an EU regulatory framework on crypto-assets, consisting of both the proposal for a new Regulation on Markets in Crypto-Assets (MiCAR)8 as well as a new proposal for a Regulation on a Pilot Regime for Market Infrastructures Based on Distributed Ledger Technology (PilotR).9 This article focuses on the latter. MiCAR and PilotR are closely related. Article 3(2) MiCAR defines crypto-assets as ‘a digital representation of values or rights that can be stored and traded electronically, using distributed ledger technology or similar technology’. Hence, crypto-assets by definition use DLT-based infrastructures. Yet, as we will show, the PilotR Proposal covers merely a subset of such crypto-assets. PilotR will introduce a so-called ‘sandbox’ approach, creating a controlled space with temporary derogations from existing rules to facilitate innovation and give regulators an opportunity to gain experience in DLT-based market infrastructures.10 Since its first adoption for financial services by the UK Financial Conduct Authority,11 the regulatory sandbox concept has been applied in more than 60 countries.12 Even though several EU Member States have adopted a sandbox approach, concerns over deviating from mandatory EU financial law and putting the main privilege of EU membership (ie the ‘EU Passport’) at risk have limited the space for experimentation. The PilotR responds to the need to take action at EU level. The instrument chosen (a regulation) ensures a harmonized innovation and learning process across the European Single Market with regard to DLT market infrastructures. In the remainder of this article, we briefly discuss the challenges relating to the regulation of DLT market infrastructures (Section 2), give an overview of PilotR (Section 3), and provide some critical reflections to be considered in the ongoing legislative procedures (Section 4). At the end, we review PilotR in the context of the international sandbox debate (Section 5). 2. DLT market infrastructures as a regulatory challenge Terminology: DLT and market infrastructure Financial market infrastructures Financial market infrastructures (FMIs) facilitate the clearing, settlement, and recording of payments, securities, derivatives and other financial transactions.13 They include payment systems, central counterparty clearing houses, central securities depositories (CSDs), securities settlement systems (SSSs) and trade repositories.14 Given that PilotR deals with securities and financial instruments, looking at FMIs in relation to these financial assets provides us with some valuable context. A CSD, as a centralized ledger provider, holds a master copy of the ledger of all transactions in a given security and performs the process of clearing, settlement and recording. Then, intermediaries with access to the CSD hold an account with that CSD; those accounts constitute a copy of the master copy (Figure 1). Figure 1 Open in new tabDownload slide CSD system for securities settlement. Figure 1 Open in new tabDownload slide CSD system for securities settlement. Once a transaction takes place it must be reconciled on all ledgers concerned. This typically happens after transactions are settled individually on each ledger, for instance daily at the close of business. If financial securities are ‘purchased’ (ie exchanged for fiat currency), clearing and settlement takes place both through a security leg and a payment leg. This process typically takes 1–3 days.15 In the meantime, both securities and money are often held as collateral and are rendered unavailable for other economic purposes. DLT market infrastructures DLT market infrastructures are aimed at replacing the centralized ledgers in today’s market infrastructures with distributed ledgers. A distributed ledger is ‘a database that is consensually shared and synchronized across networks that are spread across multiple sites, institutions, or geographies, allowing transactions to have [multiple private or] public “witnesses”’.16 The data sharing results in a sequential database distributed across a network of servers, which together function as a ledger (Figure 2).17 Distributed ledgers are characterized by the absence or minimal presence of a central administration and data storage. They are, hence, ‘distributed’ in the sense that the authorization for the recording of a given piece of information results from the software-driven consensus of many data-storage points (‘nodes’). Coupled with cryptographic solutions, such features curtail the risk of data manipulation, thereby solving the problem of having to trust any third-party data-storage service provider.18 Furthermore, since all nodes run the same software code and store, in principle, the same data, all nodes have simultaneous access to the data stored, resulting in an enhanced degree of transparency. Other ledger operators can observe if one ledger undertakes to rewrite the data, hence only if the majority of them agree (which usually happens by virtue of a pre-defined consensus mechanism) can datasets be amended. Figure 2 Open in new tabDownload slide DLT set-up. Figure 2 Open in new tabDownload slide DLT set-up. Distributed ledgers are usually paired with a blockchain protocol.19 Blockchain refers to the storage of data in bundles (‘blocks’) in a strict time-sequenced series that links each block, through a time stamp, to the previous and subsequent blocks. The blockchain renders data corruption more difficult, because a successful cyberattack would require simultaneously corrupting not just one set, but multiple sets of data (that is, the whole blockchain) as well as the time stamps. DLT can be either permissioned (closed) or permissionless (open), and either public or private.20 The first distinction (closed/open) reflects which entities can operate a node and thereby join in the consensus mechanism of validating transactions (referred to as ‘miners’ in Bitcoin terminology). The second distinction (public/private) reflects who can read the information on the ledger and initiate transactions on it (the owners of a ‘wallet’ according to Bitcoin terminology). Going by this taxonomy, the Bitcoin ledger is both permissionless (open) and public. However, since they avoid the governance and accountability issues prevalent in Bitcoin-style ‘public ledgers’, permissioned (closed) and private DLTs so far have the greatest potential when it comes to DLT market infrastructures.21 Opportunities DLT proponents hope to realize a set of opportunities: First, a synchronized and shared ledger potentially enables automatic clearing, settlement, and recording of financial transactions without intermediaries, potentially at lower costs22 than hierarchical ledgers. Secondly, DLT is expected to reduce settlement times from the typical T + 3 days to close to T + 0.23 This could reduce counterparty risk; in turn, less collateral would be necessary during the settlement period.24 Thirdly, the DLT-specific transparency and accounting trail may enable better risk management25 and enforcement, but its full potential for enhanced resilience may only truly be seen in the context of cybersecurity because a distributed ledger enables other nodes to continue operations even if one or more are compromised. Finally, DLT allows for so-called ‘smart contracts’26 which refer to computer code that automatically executes contract terms upon the fulfilment of specified conditions. For example, interest (coupon) payments may be automatically transferred to bondholders on the ledger when they are due. This enhances trust because, once coded on the immutable ledger, the parties can no longer interfere in contract execution.27 Challenges DLT is no panacea. It does not make inaccurate data accurate28 (irrespective of why the data were wrong in the first place), it does not remove credit risk which remains in place between deal execution and settlement,29 and it does not extinguish the threat posed by cyberattacks on wallets and wallet providers. Moreover, there are new risks particular to DLT, which we group loosely into four categories. Data governance: The fact that DLT relies on data storage across multiple nodes, so each node operator has access to the data stored on the ledger,30 potentially raises concerns over data privacy, insider trading, and market abuse.31 Because DLT is supposed to be immutable, there are also concerns over how to change falsified information, for instance, in response to a court decision that requires the title to an asset to be updated on the ledger. Ledger governance: Given that DLT relies on algorithms and a potentially large number of nodes, questions arise as to who is practically and legally accountable for its operations. If the servers are located in different jurisdictions with no central entity, there is also a question of which laws apply and which courts could rightfully assert jurisdiction.32 Systemic risks: The network character of DLT enhances systemic risk since it results in technical interlinkages which may be relevant under the ‘too connected to fail’ test for systemic risks.33 Further systemic risks stem from automation: if many smart contracts are self-executed in response to an event, this could trigger contagion and adverse feedback loops.34 Knowledge risks: As with all immature technologies, there will be both technical and regulatory failures delivering unintended consequences. This demands that regulators be at the top of their game with regard to old and new technologies alike.35 3. Regulatory approach PilotR is designed to achieve nothing less than the ‘squaring of the circle’ by ensuring mutual learning, openness to innovation and risk controls all at the same time. Scope: DLT trading and settlement PilotR retains control over risk by rigorously limiting the scope of the learning environment.36 Such limits are composed of six elements. The first element is allowing only certain actors—DLT multilateral trading facilities (DLT MTFs) and DLT securities settlement systems (DLT SSSs)—to benefit from the regulatory safe space. A DLT MTF is in principle an MTF as defined in MiFID II37 (subject to further conditions). Meanwhile, a DLT SSS—without stating so—seems to rely on the SSS definition in Article 2(1)(10) CSDR. The second element is limiting the tradable and settlement assets to shares and bonds. This follows from the definition of ‘DLT transferable securities’ in Article 2(5) PilotR. With that, PilotR excludes the third type of transferable securities we know from Article 4(1)(44)(c) MiFID II: ‘securities other than shares and bonds’ are not ‘DLT transferable securities’. Furthermore, since PilotR only deals with transferable securities, it does not extend any privilege to other financial instruments, most notably derivatives and money market instruments. One question to ponder here is whether units of collective investment schemes are covered by PilotR if they are issued as either shares or bonds. This is addressed in a draft report by the European Parliament, which suggested explicitly including DLT exchange-traded fund units in PilotR’s scope.38 We second that view. Turning to the third element, PilotR requires a technical feature, meaning that these shares and bonds must be issued, recorded, transferred and stored using DLT, while DLT is defined as ‘a class of technologies which support the distributed recording of encrypted data’ (PilotR Article 2(1)). Given the use of ‘and’ here as a connector among the requirements it would seem insufficient to use DLT for transfer only while ultimately recording on legacy systems. We question why this option is restricted, as amid the growing prevalence of DLT, new (currently unforeseeable) modes of transfer and storage could be developed. Interestingly, PilotR’s DLT definition is the same as in Article 3(1)(1) MiCAR. Thus, securities covered by PilotR will be crypto-assets under MiCAR, but exempted from MiCAR’s scope by virtue of Article 2(2)(a) MiCAR since MiCAR defers to EU securities law to deal with financial instruments such as shares and bonds. We also note that the definition of DLT is quite broad. It seems to be sufficient that the data are encrypted and recorded in a distributed fashion; in theory, any back-up storage device could be understood to constitute DLT. Accordingly, the DLT definition requires some rethinking for sure, which is already underway in the draft report by the European Parliament with regard to MiCAR,39 but—oddly—not in the equivalent report for PilotR.40 To avoid inconsistencies, we encourage regulators to ensure consistency between MiCAR’s and PilotR’s DLT definition. The fourth element here relates to permissible activities. An MTF must admit DLT transferable securities to trading, and an SSS settles transactions in DLT transferable securities against payment.41 Trading is covered by PilotR to unlock opportunities for DLT-based disintermediation,42 while the inclusion of settlement is aimed at merging the trading and post-trade environments43—a necessity for the envisaged acceleration of settlement to ‘real-time settlement’ (see section ‘Opportunities’). Beyond trading and settlement, FMIs also execute clearing and recording, as defined by the CPMI Principles.44 These activities are not explicitly mentioned in PilotR, yet an MTF is allowed to also record, to settle transactions and to provide safekeeping in relation to DLT transferable securities. We can only speculate as to why clearing and recording are not covered. One possible explanation is the absence of EU legislation from which exemptions are required for the clearing of shares and bonds: the clearing obligation pursuant to Article 4 EMIR and Article 29 MiFIR extends to derivatives only.45 In the same vein, recording is largely governed by the rules of EU/EEA Member States.46 To allow for the smooth functioning of PilotR, Member States’ regulators should consider whether PilotR should be supplemented by exemptions from national legislation. Looking at the fifth element, Articles 7(1) and 8(1) PilotR limit the benefits to legal entities already authorized as investment firms and market operators under MiFID or CSDs subject to the CSDR. This means that PilotR supports innovation by incumbent firms only, and that start-ups do not qualify. It also deviates from most regulatory sandboxes worldwide, which tend to allow (or even prefer) non-authorized entities.47 Finally, the sixth element is that the activities covered by PilotR are limited in size in two ways. On the one hand, there is a limit per issuance. Only shares in issuers with less than EUR 200 million (tentative) market capitalization and bonds (including convertible bonds) with an issue size of less than EUR 500 million may be admitted to trading on a DLT MTF and recorded on a DLT SSS (Article 3(1) PilotR). While this excludes the shares of large issuers, it does not exclude their bonds, provided that each bond issue is below the limit. Smaller issuers can be completely DLT-based, with all their shares and bonds covered by PilotR. There is also a limit per authorized entity. The total value of DLT transferable securities recorded by a CSD in a DLT SSS or by a DLT MTF operator may not exceed EUR 2.5 billion (Article 3(3) PilotR). Within these limits, large incumbents may operate DLT market infrastructures as a side business to gain experience. However, in the absence of further legislative steps, they will not be able to turn their main business into a DLT market infrastructure. Procedure: mimicking MiFID/MiFIR and CSDR Operator requirement Article 2 (3) PilotR defines that all DLT Market Infrastructures are operated by an operator. That operator is in charge of the application for running a DLT Market Infrastructure, functions as an access point for the competent authority, and ensures compliance of the DLT Market Infrastructure with all applicable legislation. PilotR refers to the operator as a singular entity, a scheme where multiple nodes function collectively as operator, is impermissible. This single operator requirement is at odds with the idea of decentralized finance which aims at reducing hierarchies and silo systems; it erects (or, depending on perspective: retains) a legal barrier to innovation. This barrier may be explained by PilotR’s concept that relies, by way of exemption, on established MiFID/MiFIR and CSDR rules. Any fully decentralized approach would require an entirely novel design relating to jurisdictional competencies, accountability and responsibility across ledger participants, supervisory cooperation and sanctioning powers of competent authorities.48 In fact, regulators unfamiliar with DLT may find it difficult to allocate jurisdiction over a truly decentralized DLT country-by-country. PilotR avoids this problem through its concept of requiring an operator to apply for approval and exemptions and thus assign jurisdiction over the DLT in question to the operator’s home country authority (Article 2 (22) PilotR). That operator must ensure that the DLT MTF and CSD have, and apply, a clear and detailed business plan, rules, and terms of use, clear and unambiguous information on their website, sufficient IT and cyber arrangements, operational risk procedures, segregation of funds, reliable and retrievable records, and a strategy for transitioning out of, or winding down, operations (cf. Article 6 PilotR). These elements all contribute to the safe and reliable operations of DLT, and information about them shall accompany the application to operate a DLT market infrastructure. In particular, the applicant’s business plan as well as the rules and terms of use pose specific questions regarding the governance of DLT market infrastructures which we discuss separately in section ‘Settlement Finality: PilotR versus the SFD’). PilotR as exemption from MiFID/MiFIR and CSDR PilotR relies on a system of exemptions from, and requirements set in lieu of, existing MiFID/MiFIR and CSDR requirements. The regulatory technique here is the same both for MTFs and SSSs: for MTFs, MiFID and MiFIR apply, while for SSSs, the CSDR applies, unless the operator (i) has requested and been granted an exemption from certain provisions available for exemption, (ii) complies with a set of general obligations to set the rules and meet minimum standards for the DLT market infrastructure operations and (iii) complies with a set of conditions and, at the discretion of the competent authority, additional compensatory measures. Both MTF operators and CSDs must put forward an exemption request. An MTF operator may ask to be relieved from the CSD requirement of Article 3(2) CSDR. If the relief is granted the operator may record the securities on a distributed ledger. Essentially, the MTF is then allowed to expand its services from the facilitation of trading to also covering settlement and the recording of transactions. If the operator does not ask for relief, it needs to rely on a CSD which may or may not operate a DLT SSS subject to Article 5 PilotR. Furthermore, a proposed MiFID amendment also allows for exemptions from the rules governing MTF participants.49 It is unclear to us why this new rule will be incorporated into MiFID itself, rather than through PilotR. CSDs can request exemptions from a list of specified CSDR provisions (Figure 3). These are bundled into six blocks, each of which comes with specific requirements: one block relates to the securities accounts and book-entry; one relates to delegation; one relates to participants in the SSS; one relates to cash settlement and delivery-vs-payment; one relates to access to the SSS; and one relates to settlement finality (cf Article 5(2) to (6) and 5(8) PilotR). Figure 3 Open in new tabDownload slide Exemptions available to DLT SSSs. Figure 3 Open in new tabDownload slide Exemptions available to DLT SSSs. Given the opportunity for disintermediation through the use of DLT, the opening for DLT MTFs to vertically integrate from trading to settlement is welcome. However, it is surprising that the reverse is not catered for, as there is no exemption available to a CSD that also wants to facilitate trading. This may change following the European Parliament Committee’s suggestion to let both DLT MTFs and CSDs request to qualify as DLT Trading and Settlement Systems (TSSs).50 Conditions and compensatory measures Exemptions from MiFID/MiFIR and CSDR come with three sets of conditions: (i) general conditions; (ii) specific conditions for certain exemption requests; and (iii) so-called compensatory measures proposed by the applicants, and/or induced by the competent authority. (1) All exemption requests must be proportionate, limited to the MTF or SSS subject to PilotR, and justified to the cause.51 Some exemption requests must also demonstrate that the rules from which an exception is being sought are incompatible with the use of the DLT in question. This is probably a redundant addition to the general justification requirement. While there is no requirement for operators to provide a genuine innovation, as is the case for some regulatory sandboxes,52 the justification requirement in PilotR may entail a similar standard. We doubt, however, that regulators are well-qualified to assess the degree of technical innovation as part of a traditional supervisory process.53 (2) With regard to specific conditions, if exempted from the rules on securities accounts and book-entry, for instance, both MTF operators and CSDs must still ensure that the securities are properly recorded on the ledger, that the number of securities on-ledger match the number of securities circulating, and that those securities can be allocated to their owners at all times (Articles 4(2) and 5(2)(b) PilotR). The impact on innovation of that condition rests on the question of who is a ‘participant’ in the system. If we assume that the custodian is the ledger participant and ‘owner’ in the reading envisaged by the provision, this condition expresses common sense only; that is, any custodian can function as such only if it can identify the assets in custody. Such a reading would require, however, a non-legal reading of ownership, given that custodians are owners of the shares and bonds held in custody only in some, but certainly not all, legal systems within the EU and EEA. For instance, in the case of bearer shares, often the custodial client is the ‘owner’ in a legal sense. We do not think that PilotR intends to require that the custodial clients’ data must be recorded on the ledger itself. If, however, the custodial client (the shareholder or bondholder) is a ledger participant, imposing the requirement that all securities once recorded could be segregated from that of any other member, participant, issuer or client raises the bar when compared to existing CSDs that operate omnibus accounts where securities held in the CSD’s own name are only segregated from that of all clients collectively. This would also mean that each custodial client must opt-in to a new custodial infrastructure to participate in the DLT. As such, we argue in favour of an open standard and ask for caution when using legally charged terms such as ‘ownership’ in the context of PilotR. Open terms like ‘holder of an entitlement’ and deference to definitions in the system’s business plan are preferable. Furthermore, if a CSD wants to establish new types of SSS participants, it must provide assurances that such participants are of good repute, fit and proper, and have a sufficient level of ability, competence, experience and knowledge with regard to the post-trading and functioning of DLT (Article 5(4) PilotR). Such a requirement de facto excludes the custodial clients as ledger participants and as such necessitates some degree of intermediation to remain, which is at odds with the rationale of employing DLT in the first place (see section ‘Oppurtunities’). (3) MTF operators and CSDs must comply with ‘additional compensatory measures that the competent authority which granted the specific permission may deem appropriate’.54 Given that applicants must already meet a number of requirements, it remains dubious as to what additional compensatory measures can be expected, and how these measures relate to the existing safeguards. This question is important since certain exemption requests must be accompanied by proposals for such compensatory measures. Competent authority and ESMA’s involvement Articles 7 and 8 PilotR require specific permission to operate DLT MTFs and SSSs to be granted by the competent authority of the home member state.55 The competent authority is, in principle, the same authority as the one in charge of the authorization under MiFID/MiFIR and CSDR, yet Member States may enact different provisions to reflect on the special nature of DLT. Before deciding, the competent authority must seek the ESMA’s ‘non-binding opinion on the application … and recommendations on the exemptions requested’.56 Furthermore, to ‘promote the consistency and proportionality of exemptions granted’, the ESMA shall consult competent authorities in other Member States and ‘take the utmost account of their views in its opinion’.57 The same approach—consulting with the ESMA—is foreseen for the withdrawal of the special permission or any exemption granted. The competent authority then may or may not consider the ESMA’s non-binding opinion. In any case, the ESMA will publish on its website a list of all such specific permissions, with their start and end dates, along with the exemptions granted. The involvement of the ESMA results in an intense knowledge exchange across competent authorities, as well as some openness to innovation paired with some desirable standardization across the European Single Market. At the same time, assembling the opinion(s) is time-consuming and slows down innovation. Governance: the business plan approach A novel approach PilotR addresses the perennial issue of governance and accountability in distributed ledgers by requiring the appointment of one operator that holds the special permission. It then takes a truly innovative approach to the rights, obligations and accountability of DLT participants: it leaves the operator to determine how functions and obligations are distributed or whether they remain in the hands of the operator or other parties. This is a substantial departure from the status quo where financial market law tends to define the role of each type of intermediary, and each of them is explicitly accountable for their activities as defined by their intermediary activity or entity status. While Articles 4–6 PilotR put a number of obligations on the assigned operator, these obligations are primarily of a procedural nature vis-à-vis the competent authority. With regard to the substance of the DLT operations, the operator itself defines ‘the rules under which the DLT market infrastructure shall operate, including the agreed upon associated legal terms defining the rights, obligations, responsibilities and liabilities of the operator of the DLT market infrastructure, as well as that of the members, participants, issuers and/or clients’.58 All of these matters can and must be defined within the business plan. Instead of defining the different roles making up the financial market infrastructure (CSDs, clearing houses, etc.) and regulating the operator of each activity, PilotR grants discretion to the operator (and in the real world, all DLT participants jointly). Through what we call herein the ‘Business Plan Approach’, PilotR adopts an overall market infrastructure view as opposed to the conventional institutional perspective. Openness to innovation The Business Plan Approach comes with obvious advantages with regard to openness to innovation and as such gains our full support. For instance, the operator can assign to, and thus free itself of responsibility for, tasks allocated to other participants, notably to the nodes in a distributed network. Technically, this is achieved by requesting an exemption from Articles 19 and 30 CSDR following Article 5(3) PilotR, which by omission allows exemptions from Article 30(1) (a) and (b) CSDR that otherwise would make the operator accountable for the actions of outsourcing providers, such as those operating nodes and other parts of the DLT market infrastructure. Given the decentralized nature of DLT, it would be highly impractical for one operator to be accountable for the actions of largely autonomous nodes, so we appreciate this departure from the conventional financial law ‘outsourcing perspective’, even if it comes with some challenges (see the section ‘Challenges' below). The operator is asked not only to set the rules, but also to outline the sanctions and the enforcement mechanism in its application: PilotR requires the operator to ‘specify the governing law, the pre-litigation dispute settlement mechanism and the jurisdiction for bringing legal action’.59 Of course, a business plan cannot override mandatory law, hence public intervention powers, administrative sanctions and criminal law will continue to apply. At the same time, the arrangements will be unable to prejudice legal rights granted to third parties not part of the DLT. Yet, with regard to intra-ledger rights and obligations, the business plan can stipulate rights and obligations, as a quasi-contractual tool. As a safeguard against undesirable opportunism, the governance arrangements proposed by the operator will be reviewed by the competent authority and the ESMA before the specific permission is granted. Such an approach makes a lot of sense in a DLT environment where innovators may be better informed about all of the technical opportunities and may know how to best address the challenges resulting from them when compared to the regulators. Indeed, PilotR may here also serve as an example for other areas where regulators lack the information and insights required to draft suitable legislation.60 Challenges Yet, the Business Plan Approach will also come with foreseeable challenges. One issue is the extent to which other DLT or market participants are legally bound by the rules defined by the operator. Do we apply a contractual or public law perspective for that purpose? Pertinently, do all rights and obligations apply only to DLT or market participants that have signed up to them? Does involvement with the ledger as such come with an implicit consent, or do the rules apply as public law meaning that consent is not required? Consent can be assumed only for arrangements sufficiently transparent to be consented to. We doubt that any business plan can be sufficiently detailed for third parties to fully understand their technicalities, and those technicalities will matter if anything goes wrong. In practice, we suggest that the competent authority and ESMA require the operator to install a mechanism to ensure consent before market participants get involved with the ledger. For that purpose, operational details may be stipulated by way of contracts incorporating technical specification sheets. We could further envisage that the operator sets up a technical pilot where nodes test their operational rights and obligations under market conditions in an isolated environment before signing up with binding effect. The situation is different with regard to legal details: legal complexity is often present in financial infrastructure contracts. To some extent it can be remedied through applying the contra proferentem doctrine, that is, interpretation against the draftsman where doubts remain, taking into account the technical and financial expertise to be expected from all entities volunteering to function as nodes. Another pressing question is to what extent is the operator really entitled to impose sanctions and enforcement mechanisms upon third parties? Here, we draw an analogy to rules and sanctioning regimes prevalent at stock exchanges and other self-regulating financial infrastructure. By and large, if the competent authority and ESMA require the operator to install a mechanism to ensure consent before market participants get involved with the ledger, general contract law could govern sanctions and penalties assigned to participants for non-compliance. A matter where we would expect more legal certainty refers to what the default position is when the rules defined by the operator are silent. This question is of importance because even the most expansive business plan would be unable to capture all matters. We argue that for any matter not explicitly addressed in the business plan, the operator remains in charge to meet the infrastructure’s obligation—this follows from the exemptive nature of PilotR, whereby the operator as a MiFID investment firm, market operator or CSD needs to comply with all MiFID/MiFIR or CSDR provisions unless PilotR provides otherwise. Finally, we caution that public sanctioning usually requires some written legal text (nulla poena sine lege scriptum). This requirement has two implications. On the one hand, the regulators may be incompetent to enforce business plan duties vis-à-vis non-operator DLT participants. On the other hand, sanctioning the operator may be impossible because the operator was exempted from that very duty by way of PilotR or the business plan approved by the competent authority, as the case may be, so that no one could be held accountable by financial regulation means. Even if the non-operator market participants have indeed accepted the business plan terms, we find it difficult to imagine that third parties which have signed up to the business plan (with some of them residing in other and maybe also non-EU/-EEA jurisdictions), can submit themselves to the sanctioning powers of a competent authority by way of contract. Many of the abovementioned issues could be remedied if more than one operator could take responsibility for the implementation of some parts of the business plan. Yet, as mentioned, PilotR so far refers to the operator as a singular entity—with that requirement the PilotR obviously seeks not to deviate too far from the status quo of relying on one operator under the MiFID/MiFIR and CSDR rules. All in all, we appreciate the PilotR’s Business Plan Approach as a bold and innovative step that contributes to a true overall test-and-learn approach. Yet, we ask Parliament to further clarify the legal status of ledger participants and respective sanctioning powers of competent authorities, to ensure more legal certainty and efficient enforcement of any Business Plan stipulation. Settlement finality: PilotR versus the SFD An essential question relates to how PilotR impacts on the provisions of the Settlement Finality Directive (SFD).61 Settlement finality—the irrevocable and unconditional transfer of an asset or the discharge of an obligation62—is a fundamental concept in risk management, particularly with regard to the event of a participant’s insolvency.63 Hence, according to Principle 8 of the BIS Principles for FMIs ‘[a]n FMI should provide clear and certain final settlement’. However, some DLT consensus mechanisms, like the one used for Bitcoin, operate with probabilistic finality only. That is, the more nodes that confirm a transaction, the less likely it is that the transaction may be revoked.64 Therefore, there could be a need to exempt DLT FMIs from existing legislation on settlement finality, such as the SFD. DLT MTF operators that facilitate settlement and recording (Article 4(2) PilotR) are not subject to the SFD. Instead, Article 4(3)(d) PilotR simply mandates that they provide clear information about the settlement of transactions and define the moment at which settlement finality is given. This enables the recognition of finality by probabilistic means; however, the operator must define finality by detailing the working mode of its consensus mechanism. This will then apply for all legal purposes, for instance when a certain number of nodes has validated the transaction. CSDs operating a DLT SSS would normally be subject to the SFD. However, the SFD applies to a defined set of participants only (Article 2(f) SFD), while CSDs operating a DLT SSS can request to also admit other entities as participants (Article 5(4) PilotR, exempting from Article 2(19) CSDR). For this reason, the proposed PilotR recitals note that an exemption from the SFD should be available specifically to such DLT SSSs that are exempted from the participation requirement.65 This, presumably, is the purpose of Article 5(8) PilotR, which allows for exemptions from the SFD specifically for CSDs that are also exempted under Article 5(3) PilotR. We assume this reference to Article 5(3) PilotR is a mistake; it should presumably instead have referred to Article 5(4), which exempts from the participation requirement. Even then, given the functioning of DLT consensus mechanisms, and particularly those based on probabilistic finality, we believe that the requirement of exempting from the SFD only those CSDs that are also exempted from the participation requirement, should be reviewed. In our view, all CSDs operating a DLT SSS could benefit from an exemption from the SFD, depending on how their consensus mechanism works. Furthermore, we propose a review of the regulatory technique. Currently, Article 5(8) PilotR allows for exemptions from Article 39(1) CSDR, which essentially is a convoluted way of exempting from the SFD. Since the SFD applies only to systems designated by a Member State and notified to the Commission (cf Articles 1 and 2(a) SFD), an exemption from the duty for Member States to conduct such designation and notification (Article 39(1) CSDR) indirectly allows competent authorities to exempt from the SFD in its entirety, simply by omitting the designation and notification. We propose streamlining this convoluted regulatory technique and adopting explicit wording instead. New and often small companies generally have limited resources for legal counsel, so the regulatory framework should be as easy to understand as possible. EU passport The most valuable privilege of the European Single Market in financial services is the right to operate across borders. A specific permission to operate DLT market infrastructures is ‘valid throughout the Union for up to six years’.66 Essentially, the operator is granted a time-bound ‘EU Passport’. Yet, some uncertainties exist as to what activities are covered by this passport; in light of PilotR’s objective, we argue that this EU Passport covers all activities necessary to operate the DLT in question. That is, it covers the activities of all nodes and participants of the ledger and their contribution to, for instance, trading, recording and settlement. In turn, the (potentially many) ledger participants do not require an additional licence, even when these participants may reside in a different Member State and even if their business may involve that of an investment firm subject to MiFID or a CSD. This view coincides with PilotR’s requirement that participants need to meet certain qualitative criteria, including good repute (Article 5(4) PilotR). It also coincides with Article 5(3) PilotR, which exempts from the outsourcing rules under the CSDR. This may suggest that PilotR treats ledger participants as outsourcing providers, and an exemption from Article 19 CSDR would then explicitly exempt from the authorization requirement for outsourcing of core services. While Article 5 PilotR applies to CSDs only, the same holds for DLT MTFs because they are neither subject to CSDR nor do the MiFID rules about outsourcing67 cover settlement activities. However, if the DLT is used for MiFID activities (eg to match parties for trading), a question arises as to whether nodes need authorization subject to MiFID. In this case, we still argue that PilotR must be interpreted as providing an EU Passport covering the activities of all nodes and participants of the ledger so that these do not require separate licences. The EU Passport addresses the root cause of why regulators have so far refrained from deviating from EU law. In smaller markets, where every transaction is to some extent cross-border, in the absence of an EU Passport very little innovation would take place. In such an environment, PilotR grants not only exemptions from rules that restrain their activities, but also allows the inclusion of participants across the Single Market which are then also covered by PilotR. 4. Policy considerations We believe that the PilotR Proposal is a significant step in the right direction for EU financial law. Yet, room for improvement exists with regard to PilotR’s objectives, its scope, the approach to supervision as well as technical consistency. Objectives PilotR is part of the EU’s DFS 2020, which lays out four priorities:68 (i) removing fragmentation in the Digital Single Market; (ii) adapting the EU regulatory framework to facilitate digital innovation; (iii) promoting data-driven innovation in finance by establishing a common financial data space; and (iv) addressing the challenges and risks associated with digital transformation. While these are sound priorities, it is not made clear how PilotR is going to contribute to each of them. In both the DFS 2020 and the Explanatory Memorandum to the PilotR Proposal, PilotR is described as a tool to address priority number two,69 while PilotR truly contributes to at least priorities one, two and four. It would be preferable if the PilotR recitals would clarify how it seeks to further these (sometimes conflicting) priorities. Furthermore, neither the DFS 2020 nor the Explanatory Memorandum to the PilotR Proposal discuss how the pilot regime is supposed to coexist with complementary measures such as innovation hubs in EU Member States and national legislation, for example on the recording of securities. Complementarity is crucial for success here. We encourage knowledge exchange and cooperation among both EU and national institutions (which can of course take place informally, without the need for formal procedures under PilotR). Scope We would, in particular, request that some restrictions on PilotR’s scope be reconsidered. DLT definitions According to Article 2(5) PilotR, DLT transferable securities must be ‘issued, recorded, transferred and stored using a DLT’. We hold this to be an unnecessary limitation of PilotR’s scope, since the use of DLT for only parts of this process could be quite practical.70 It also deviates from how Article 3(1)(2) MiCAR defines crypto-assets, which ‘may be transferred and stored’ using DLT. We propose replacing ‘and’ with ‘or’ in the ongoing legislative process. Size limits We find the different value thresholds in Article 3(1) PilotR between shares (EUR 200 million per issuer) and bonds (EUR 500 million per issuance) to be inconsistent for no obvious reason. While the risk mitigation rationale is clear in these rules, it is unclear why PilotR operates with such vastly different limits for equity and fixed-income securities. We appreciate the European Parliament’s suggestion of having the same limit for shares and bonds.71 Yet, we do not share the European Parliament’s approach in suggesting ‘a more prudent approach’ by reducing both limits to EUR 50 million.72 Such a low limit would restrain any meaningful use of DLT FMIs, given that the average market capitalization of listed issuers at EU/EEA markets amounts to EUR 1.2 billion and the average bond size capitalization amounts to EUR 91 million.73 Therefore, EUR 500 million for each of stocks and bonds sounds like a reasonable compromise. Moreover, we would propose increasing the overall amount a DLT FMI can operate under PilotR to EUR 5 billion. We propose these higher limits in light of the significant safeguards provided by mandatory law and the Business Plan Approach, which also enable a flexible reaction on the regulators’ part in the event that deficiencies become apparent. A similar view to increase the limits has now been adopted by the Council as part of the ongoing legislative process.74 Asset classes PilotR is so far limited to shares and bonds.75 We hold that the size limits in Article 3 PilotR are better suited for safeguarding investors and the financial system than are the rigid restrictions on asset classes. Certainly, by covering shares and bonds only, PilotR avoids dealing with possible exemptions from rules specific to derivatives, for example the clearing obligation under Article 4 EMIR and Article 29 MiFIR. This makes for a simpler pilot regime, but it also leaves out significant opportunities for learning and innovation that could be achieved with only marginally higher risk, provided that other safeguards are in place. Hence, we suggest either expanding the scope of PilotR beyond shares and bonds now, or to consider mechanisms for adjusting the scope much earlier than facilitated by the procedure outlined in Article 10 PilotR. For instance, interim reports by ESMA and the Commission, respectively, could facilitate modifications to the pilot regime along the way, after two or three years for instance, before the final review after five years as suggested by the current PilotR Proposal. Activities PilotR exempts from the CSDR and the SFD only, not from MiFID, for example. This is unproblematic as long as operating the DLT market infrastructure is seen as a settlement activity. However, you could also envision the use of DLT to match parties for trading, for example, which is subject to MiFID. In this case, questions may arise, for example whether nodes and other DLT participants are seen as outsourcing providers for the DLT operator and need their own authorization following the MiFID rules about outsourcing.76 Other similar issues may also arise insofar as DLT is used for activities in the scope of EU financial law other than the CSDR and the SFD. Ideally, PilotR should aim to anticipate and provide a clear answer to at least some of these issues, possibly through later revisions to avoid extensions to the existing legislative process.77 Market operators PilotR’s concept of designating an operator is counterintuitive to the philosophy underlying DLT, yet understandable in light of the PilotR’s approach that relies on MiFID/MiFIR and CSDR as starting points (see section ‘Operator Requirement’). Nevertheless, we would recommend reviewing several aspects of this concept. Most fundamentally, there may be no need for a designated operator at all. One could, for example, imagine a system where all operators of nodes on a DLT were mutually accountable for its operations in the absence of the business plan explicitly assigning accountability to one node or several nodes, respectively. This would take the innovative Business Plan Approach of Article 6(1) PilotR one step further, in line with the purpose of facilitating completely new ways of setting up DLT FMIs.78 Alternatively, simply removing the requirement for the operator to be an authorized investment firm, market operator or CSD would stimulate innovative organizational models. For example, imagine that a clearing house, or a security-holder registry provider (eg Computershare), wants to run a DLT market infrastructure, or that a number of custodian banks would establish a joint venture to operate a DLT market infrastructure. Forfeiting regulatory status for the operator would enable this type of innovation. The draft report by the European Parliament is a step in the right direction as it suggests that a CSD should also be allowed to take on the role of an MTF (not just the other way around), and that legislation should apply based on the activities performed rather than the entity performing them,79 following the principle of ‘same activity, same risk, same rules’.80 This reasoning could be taken one step further to also include entities other than investment firms, market operators and CSDs, including unregulated entities. This seems unlikely to come out of the ongoing legislative process, however, but the Council is at least proposing changes to ease the authorisation proces.81 A removal of the authorization requirement is further underpinned by the Digital Finance Package aiming ‘to boost responsible innovation in the EU’s financial sector, especially for highly innovative digital start-ups’.82 From this perspective, it is surprising that PilotR is effectively drafted to enable piloting by authorized incumbents, not by start-ups. It is also unclear what other measures the EU is suggesting instead, to support the start-ups highlighted by the Digital Finance Package. Hence, we would suggest also allowing otherwise unauthorized entities to be granted a specific permission to operate a DLT MTF or SSS under PilotR provided they comply with certain minimum requirements. Supervision We appreciate the need for the ESMA to play a central role in the pilot regime, as outlined in Articles 7–10 PilotR. Even if these rules put the formal authority with the competent authorities, it is to be expected that the ESMA’s non-binding opinions will set a clear precedent. We believe this system could work, provided that the ESMA truly listens to the concerns of competent authorities and is sufficiently staffed with qualified people for the job. The estimate of EUR 150,000–300,000 being required annually to pay for the ESMA’s review and coordination role may be on the optimistic side.83 Further, it would be wise if PilotR explicitly gave national competent authorities the power to enforce all rules stipulated by the operator under the ‘Business Plan Approach’. Without such powers, there is a clear risk of regulatory loopholes if the operators can free themselves of legal accountability by assigning tasks to other market participants, while competent authorities can enforce the rules only vis-à-vis the operator. Due to the lack of explicit authority provided by PilotR, competent authorities and ESMA must require to be given such powers through the operator’s business plan terms, as a prerequisite for awarding the specific permission under PilotR. Technical inconsistencies Finally, some technical matters deserve review. Exemptions Exemptions from the participation requirements are regulated differently for CSDs and MTF operators, respectively. For CSDs, Article 5(4) PilotR essentially allows participants beyond the typical intermediaries that otherwise may be participants to a CSD, effectively facilitating disintermediation. Somehow, the equivalent rule for MTF operators is proposed as an amendment to MiFID rather than as part of PilotR.84 Interestingly, while exemptions under PilotR are granted for up to six years, exemptions under the proposed MiFID amendment are valid for a maximum of four years only. Given PilotR’s explicit rationale for six-year exemptions to allow some time for market participants to adjust following the ESMA’s final report,85 it seems natural that exemptions under the proposed MiFID amendment should follow the same logic and be granted for the same period. Requirements We see no reason why Articles 5(2)(a), 5(3)(a) and 5(6) PilotR all require that the rules from which an exception is granted are incompatible with the use of the DLT in question, while the same is not required by Articles 5(4), 5(5) and 5(8) PilotR, nor by the proposed MiFID amendment for DLT MTFs.86 This requirement is probably also redundant on top of the general requirement for exemptions to be proportionate and justified by the use of DLT. Therefore, in our view, the incompatibility requirement should be removed altogether. Furthermore, the requirement in Article 5(7) PilotR that CSDs ‘shall give access to other CSDs operating a DLT securities settlement system or to DLT MTFs’ applies already when a CSD ‘has requested an exemption’, irrespective of whether that exemption is granted or not. If this is a mistake, it should be corrected prior to PilotR’s adoption. 5. PilotR as the EU’s regulatory sandbox? PilotR is the EU’s response to the international trend of regulating fintech innovation. Learning as a regulatory objective To facilitate mutual learning with innovative firms, regulators may adopt various strategies. Indeed, a number of jurisdictions, including all EU Member States,87 have formalized interactions with innovators through innovation hubs. Other regulators have deliberately taken a permissive or laissez-faire approach, with China being a prominent example until 2015, since when it has pursued a more cautious path.88 Regulators could also assess innovation case-by-case, which is typically accompanied by no-action letters, restricted licences, special charters and/or partial exemptions for innovative firms.89 Finally, regulators engage in structured piloting, often organized through formalized regulatory sandboxes that are now operational or under establishment in around 50 jurisdictions.90 All of the abovementioned strategies can, of course, provide insights that will eventually lead to foundational reform of financial regulation. Although these strategies may seem to diverge, they could in fact complement each other.91 For example, new fintech firms may first need informal guidance for their early technological development, which can be facilitated through an innovation hub. Then, a regulatory sandbox can provide a safe environment for testing of the given technology on real customers. When the fintech firm grows out of defined, risk-mitigating boundaries for sandbox operations, there could be a period of case-by-case restricted licensing before the fintech firm must apply for a fully-fledged licence under conventional (or reformed) regulations. The PilotR provides no such comprehensive framework. But it is a step in this direction that will interact with existing measures at the Member State level, which so far have been confined in their effectiveness due to mandatory EU financial law. The PilotR learning process Articles 9 and 10 PilotR stipulate an elaborate process for facilitating and codifying learning in an effort to collect knowledge, feeding into a long-term regulatory response to DLT market infrastructures. Specifically, in exchange for the exemptions, operators face intensified duties to cooperate with the competent authority and the ESMA, to notify them of specific events, and to provide information upon request. The competent authority, after consulting with the ESMA, may require corrective measures based on the information provided, and operators must submit formal reports every six months. The ESMA plays a critical coordination role here ‘ensuring consistent approaches and convergence in supervisory outcomes’.92 Based on collective feedback, the ESMA will submit annual reports to the Commission (Article 9(6) PilotR) and a final report within five years from PilotR’s entry into force (Article 10(1) PilotR). The intention here is to allow some time for ramping up the pilot regime, then around three years of learning before the final report is submitted, and finally some more time for participants to adjust to any proposed changes.93 Consequently, the final report is submitted after five years and the ‘special permission’ awarded to participants is valid for up to six years (Articles 7 and 8 PilotR). Based on the ESMA’s report, the Commission will report to the European Parliament and Council with an analysis of whether the pilot regime should be extended for another period, extended to other financial instruments beyond shares and bonds, amended, made permanent with or without amendment or terminated. This timeframe is long, considering the pace of fintech innovation. Hence, in its draft report, the European Parliament suggested that the Commission, based on advice from the ESMA, submits an interim report after three years assessing the need for potential adjustments to or discontinuation of the pilot regime.94 We would also suggest that the extension of PilotR may start earlier than currently foreseen in the legislation. PilotR vis-à-vis other regulatory sandboxes When we compare PilotR to other regulatory sandboxes (while being considerate of the fact that there are significant differences between the sandboxes in around 50 jurisdictions globally95), we find, on the pro-innovation side, that PilotR operates with longer timelines than most sandboxes. Exemptions are valid for up to six years, compared to the typical 6–24 months (plus extensions).96 However, this long duration comes at the price of a relatively narrow set of exemptions under the weight of heavy regulatory requirements. PilotR’s narrow set-up is partly a consequence of its greatest benefit, namely the EU Passport that allows firms to expand across the Single Market, which should result in more participants in the pilot regime and, consequently, more competition and more innovation, and eventually more learning for regulators, provided that the learning is shared across competent authorities. To achieve this, PilotR stands out from other sandboxes in providing an elaborate process for such knowledge-sharing with the ESMA assuming a central coordination role. However, the ESMA’s truly binding powers in this process are limited. Thus, mandatory regulation must adopt this function, in an effort to prevent competent authorities from engaging in a ‘race to the bottom’ where Member States compete to have the most lenient (instead of the best) rules. While this risk is low if the origination and distribution of financial services takes place in the same jurisdiction, it is a particular feature of the EU Passport that origination and distribution of such services may take place in different countries, hence risks are spread all over the EU while benefits (in terms of potential income) can be concentrated in but one country. This explains the long list of detailed regulatory requirements—an approach that deviates from that of most regulatory sandboxes worldwide, which tend to favour flexibility over stipulating an exhaustive list of exemptions.97 We note that the obvious alternative—broadening the ESMA’s competences more generally and entitling it to waive certain or all provisions of EU financial law—would raise the rule-of-law concerns in some EU Member States. PilotR’s scope is also narrow along other dimensions. It covers only DLT, as opposed to fintech more broadly; it is also limited to shares and bonds only, and exemptions are granted from the CSDR and the SFD only. This narrow scope is a response to the wish for, or necessity of, an exhaustive list of available exemptions, which would impose a regulatory challenge if it were to cover a wider scope. One negative consequence, however, is to effectively block fintech’s potential to break down boundaries between conventional regulatory domains.98 PilotR constrains market actors that seek to bridge conventional supervisory domains, such as securities, banking and insurance law. Finally, the pilot regime is available to authorized entities only (ie incumbent firms), thereby deviating from most regulatory sandboxes worldwide which tend to allow (or even prefer) non-authorized entities.99 6. Conclusion The PilotR is a significant step in the right direction towards a future-proof EU regulatory framework for fintech. In particular, we appreciate the truly European scale of the pilot regime, with the EU Passport and pan-European consultation process under the auspices of the ESMA as its core, and the Business Plan Approach, where the applicant may propose rules, the assignment of functions and compensatory measures, as its main design feature. These aspects of PilotR ensure openness to innovation, while at the same time mitigating risks. Nevertheless, we encourage some clarification as to how PilotR fits into the broader objective of the DFS 2020. Moreover, PilotR represents an overly cautious step, as it combines a narrow scope with rigid mandatory rules, thereby reducing the innovation and learning potential. Finally, we ask to reconsider the idea of setting up a pilot regime for incumbents only; it remains uncertain how PilotR strengthens innovation support for start-ups—despite the explicit aim to assist start-ups expressed in the Digital Finance Package. Footnotes 1 See DA Zetzsche et al, ‘The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators’ (2019) 60(2) Harvard International Law Journal 267. 2 European Commission, Communication on a FinTech Action Plan: For a More Competitive and Innovative European Financial Sector (Communication) COM (2018) 109 final. 3 Financial Stability, Financial Services and Capital Markets Union, European Commission, ‘Communication on Digital Finance Package’ (24 September 2020) <https://ec.europa.eu/info/publications/200924-digital-finance-proposals_en> accessed 24 February 2022. 4 European Commission, Communication on a Digital Finance Strategy for the EU (Communication) COM (2020) 591 final. 5 European Commission, Communication on a Retail Payments Strategy for the EU (Communication) COM (2020) 592 final. 6 European Commission, Press Release on Digital Finance Package (24 September 2020) <https://ec.europa.eu/commission/presscorner/detail/en/IP_20_1684> accessed 24 February 2022. 7 Ibid. 8 European Commission, Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto-assets, and Amending Directive, COM (2020) 593 final. See on MiCA, DA Zetzsche, F Nunziata, RP Buckley and DW Arner, ‘The Markets in Crypto-Assets Regulation (MiCA) and the EU Digital Finance Strategy’ (2021) 16 (2) CMLJ 203–25. 9 European Commission, Proposal for a Regulation of the European Parliament and of the Council on a Pilot Regime for Market Infrastructures Based on Distributed Ledger Technology, COM (2020) 594 final. 10 See PilotR Proposal (n 9) at recitals para 5. 11 FCA, <https://www.fca.org.uk/firms/innovation/regulatory-sandbox> accessed 24 February 2022. 12 For an updated list of running sandboxes, see DFS Observatory, ‘Regulatory Sandboxes’ <dfsobservatory.co/onten/egulatory-sandboxes> accessed 24 January 2021. 13 See BIS, Principles for Financial Market Infrastructures (2012), 7. 14 See ibid 5. 15 Morten Bech et al, ‘On the Future of Securities Settlement’ (March 2020) BIS Quarterly Review 67, 68. 16 O Wyman and World Economic Forum, ‘Innovation-Driven Cyber-Risk to Customer Data in Financial Services’, 6 (2017) <http://www3.weforum.org/docs/WEF_Cyber_Risk_to_Customer_Data.pdf> accessed 24 February 2022. 17 See David Mills et al, ‘Distributed Ledger Technology in Payments, Clearing, and Settlement’ (2016) 2016-095 Fed. Rsrv. Bd., Finance and Economics Discussion Series 10–11. 18 See M Finck, Blockchain Regulation and Governance in Europe (Cambridge University Press 2019), 12–14; see also S Davidson, P De Filippi and J Potts, ‘Blockchains and the Economic Institutions of Capitalism’ (2018) 14 Journal of Institutional Economy 4, 639, 641 (arguing that blockchain technology is a new governance institution that competes with other economic institutions of capitalism, namely firms, markets, networks and even governments); P De Filippi and A Wright, Blockchain and the Law: The Rule of Code (Harvard University Press 2018), 136–40 (arguing that widespread deployment of the blockchain will lead to tech-based business practices that could prompt a loss in importance of centralized authorities, such as government, and urging a more active regulatory approach). 19 See, for example, De Filippi and Wright (n 18) 13–57 (describing blockchains). 20 See ibid 72–4 (March 2020); Benos et al, ‘The Economics of Distributed Ledger Technology for Securities Settlement’ (2019) 4 Ledger 121, 126–7. 21 Compliance becomes difficult if anyone can take part in validating transactions. Public ledgers are difficult to reconcile with privacy, insider trading and market abuse legislation. Permissioned systems require less extensive consensus mechanisms because the nodes are pre-approved (trusted), which enables faster and cheaper processing of transactions. See, for all, Benos et al (n 20) 127–8. 22 Optimistic estimates see the cost savings potential at $20 billion annually, while estimates assuming increasing efficiencies in traditional systems result in no savings at all. See Mariano Belinky et al, ‘The FinTech 2.0 Paper: Rebooting Financial Services’ (2015) Santander InnoVentures/Oliver Wyman/Anthemis 15. 23 For example, by streamlining reconciliation and reducing the number of intermediaries. See Bech et al (n 15) 75. 24 However, the cost of overnight collateral for settlement is small relative to the total cost of trade processing. See Michael Mainelli and Alistair Milne, The Impact and Potential of Blockchain on the Securities Transaction Lifecycle, 2015-007 SWIFT Institute Working Paper, (May 2016), at 28. 25 BIS Committee on Payments and Market Infrastructures, Distributed Ledger Technology in Payment, Clearing and Settlement (2017), 19. 26 The term is somewhat misleading because smart contracts are probably neither smart nor actual contracts, but merely a non-smart computer code (as opposed to artificial intelligence) that typically executes terms in existing contracts that pre-date the code itself. See Phoebus Athanassiou, ‘Impact of Digital Innovation on the Processing of Electronic Payments and Contracting: An Overview of Legal Risks’ (2017) 16 European Central Bank Legal Working Paper Series 37. 27 See Athanassiou (n 26) 36. 28 Zetzsche et al, ‘The Distributed Liability of Distributed Ledgers: Legal Risks of Blockchain’ (2018) 4 University of Illinois Law Review 1361, 1377. 29 See Bech et al (n 15) 75. 30 For example, the DLT supporting Bitcoin stores all data except the identity of the owners, which requires a private key. 31 See Zetzsche et al (n 28) 1375. 32 See Athanassiou (n 26) 30–1. 33 See R Buckley et al, ‘Techrisk’ (2020) Singapore Journal of Legal Studies 1, 6–7; Zetzsche et al, ‘Decentralized Finance’ (2020) 6(2) Journal of Financial Regulation 172, 191. 34 See BIS (n 25) 13. 35 Analogies with the 1980s to the 2000s period are sobering, when the popular adoption of computers sparked innovations such as securitization and credit default swaps. Policymakers supported these developments, which eventually facilitated the global financial crisis of 2007–2009. Cf Chris Brummer and Yesha Yadav, ‘Fintech and the Innovation Trilemma’ (2019) 107 The Georgetown Law Journal 235, 254–8. 36 PilotR Proposal (n 9) 2. 37 Under art 2 (6) PilotR and art 4(1)(22) MiFID II, an MTF is: ‘a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments’. 38 See European Parliament, Committee on Economic and Monetary Affairs, Draft Report 2020/0267(COD) (9 March 2021), at 48. 39 See ibid 43–4. 40 See European Parliament, Committee on Economic and Monetary Affairs, Draft Report 2020/0265(COD) (25 February 2021), 6–7. 41 Art 2(4) PilotR. 42 See PilotR Proposal (n 9) recitals paras 9 and 15. 43 Ibid recitals para 9. 44 See BIS (n 13) 7. 45 See ESMA, The Distributed Ledger Technology Applied to Securities Markets, European Securities and Markets Authority Report (7 February 2017), 14, para 49. 46 See ibid 16–17, paras 62–66. 47 See Dirk Zetzsche et al, ‘Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation’ (2017) 23 Fordham Journal of Corporate & Financial Law 31, 73. 48 See Zetzsche et al, ‘Decentralized Finance’ (2020) 6(2) Journal of Financial Regulation 172, 191 (laying out the challenges); Dirk A Zetzsche, Linn Anker-Sørensen, Maria Lucia Passador and Tres Wehrli, DLT-based Enhancement of Cross-border Payment Efficiency—a Legal and Regulatory Perspective, Bank of International Settlement Working Paper (2021), IV (describing the conflict-of-law issue resulting from fully decentralized ledgers). 49 Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/43/EC, 2009/65/EC, 2009/138/EU, 2011/61/EU, EU/2013/36, 2014/65/EU, (EU) 2015/2366 and EU/2016/2341 art 6(1)(4). 50 See European Parliament (n 49) 58 and 69. 51 Art 4(4), 5(7) PilotR. 52 See for example Financial Conduct Authority, Regulatory Sandbox, s 3.4 (November 2015) <https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf> [<https://perma.cc/Z5K5-3DFF>]; Autoriti Monetari Brunei Darussalem, Guidelines No FTU/G- 1/2017/1: Fintech Regulatory Sandbox Guidelines, s 7.2(a) (2017); Bank Negara Malay, Financial Technology Regulatory Sandbox Framework, s 5.1(a) (18 October 2016) <http://www.bnm.gov.my/index.php?ch=57&pg=137&ac=533&bb=file [https://perma.cc/9G8M-7R9E>]. 53 See, in the same vein, Zetzsche et al (n 47) 70. 54 According to PilotR arts 4(1)(c) and 5(1)(c). 55 The terms ‘competent authority’ and ‘home member state’ are defined in PilotR arts 2(1) (21) and (22), respecitvely. 56 Arts 7(3) and 8(3) PilotR for DLT MTFs and DLT SSSs, respectively. 57 Ibid. 58 Second paragraph of art 6(1) PilotR. 59 Ibid. 60 See, for example, Zetzsche et al (n 28) (discussing the Business Plan Approach and proposing to implement it for DLTs in the context of cross-border payments). 61 Cf Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems, OJL 166/45. 62 See BIS (n 13) 64. 63 Ibid 23. 64 BIS (n 25) 15; Benos et al (n 20) 132 (also noting that other DLT protocols exist that avoid this problem). 65 PilotR Proposal (n 9) recitals para 23. 66 Arts 7(5) and 8(5) PilotR for DLT MTFs and DLT SSSs, respectively. 67 Art 16(5) MiFID and art 31(2)(a) of Regulation 2017/565. 68 DFS 2020 (n 4). 69 Ibid 9; PilotR Proposal (n 9) 1. 70 See BIS (n 25) 11. 71 See European Parliament, Committee on Economic and Monetary Affairs, Draft Report 2020/0267(COD) (9 March 2021), 51. 72 Ibid 51–2 (which at 55–6 also suggests a procedure to subsequently increase the limits up to EUR 100 million). 73 Federation of European Securities Exchanges (market capitalization by month end February 2021 and bond issues year to date also by month end February 2021). 74 See Council of the European Union, Proposal for a Regulation of the European Parliament and of the Council on a Pilot Regime for Market Infrastructures Based on Distributed Ledger Technology, COD (2020) 267, at Articles 3 and 10. 75 PilotR Proposal (n 9) 2. 76 Art 16(5) MiFID and art 31(2)(a) of reg 2017/565. 77 See point 2(c) above, where we propose a process under which PilotR could be modified already two to three years after its adoption. 78 For further considerations regarding a comprehensive Business Plan Approach to fully decentralized DLT see Zetzsche et al (n 48) V. 79 See European Parliament (n 71) 58 and 69. 80 See European Commission (n 4) 5, 15, 16 (about the principle of ‘same activity, same risk, same rules’). 81 See Council of the European Union, Proposal for a Regulation of the European Parliament and of the Council on a Pilot Regime for Market Infrastructures Based on Distributed Ledger Technology, COD (2020) 267, at recitals para. 8a and Articles 7 and 8. 82 European Commission, Press Release on Digital Finance Package (24 September 2020) <https://ec.europa.eu/commission/presscorner/detail/en/IP_20_1684> accessed 24 February 2022. 83 PilotR Proposal (n 9) 8. 84 See (n 49). 85 See PilotR Proposal (n 9) recitals para 36. 86 See (n 49). 87 Radostina Parenti, Regulatory Sandboxes and Innovation Hubs for FinTech (2020), 58–9. 88 Zetzsche et al (n 47) 44. 89 Ibid 44–5. 90 For an updated list of running sandboxes, see DFS Observatory (n 12). 91 See Buckley et al, ‘Building Fintech Ecosystems: Regulatory Sandboxes, Innovation Hubs and Beyond’ (2020) 61 Journal of Law & Policy 55; Brummer and Yadav (n 35) 243; Zetzsche et al (n 47) 56–8. 92 Art 9(5) PilotR. 93 PilotR Proposal (n 9) recitals para 36. 94 See European Parliament (n 71) 83, 84, 87–90. 95 For an updated list of running sandboxes, see DFS Observatory (n 12). 96 Zetzsche et al (n 47) 75. 97 See Zetzsche et al (n 47) 76–7. 98 See ibid 71–2. 99 See ibid 73. Author notes * Dirk A. Zetzsche is Professor of Law, Dr iur, Dr iur habil, LLM, ADA Chair in Financial Law (Inclusive Finance), and Coordinator, Centre for Sustainable Governance and Markets, University of Luxembourg. Co-Chair, Fintech Working Group, European Banking Institute, Frankfurt, Germany. Jannik Woxholth PhD is Senior Scientist, ADA Chair in Financial Law (Inclusive Finance), University of Luxembourg. © The Author(s) (2022). Published by Oxford University Press. All rights reserved. For permissions, please email: journals.permissions@oup.com This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/open_access/funder_policies/chorus/standard_publication_model)
TI - The DLT sandbox under the Pilot-Regulation
JF - Capital Markets Law Journal
DO - 10.1093/cmlj/kmac003
DA - 2022-04-06
UR - https://www.deepdyve.com/lp/oxford-university-press/the-dlt-sandbox-under-the-pilot-regulation-fQM7HxS3vB
SP - 212
EP - 236
VL - 17
IS - 2
DP - DeepDyve
ER -